The steep drop in oil prices – the fallout of a dispute between Russia and Saudi Arabia – is laying low drillers in Colorado, but the toll would be worse if many of those companies hadn’t hedged their bets.
Oil companies commonly use “hedges” – a sort of insurance policy – to smooth out some of the volatility in the oil market.
“On a normal basis, hedges don’t move the needle,” said Tyler Hoge, a financial analyst with Enverus, an energy industry analytics firm. “They are usually a couple of dollars [on the price of a barrel of oil]. These are not normal times.”
This year’s collapse in oil prices – which fell to $20.65 a barrel for West Texas Intermediate crude from $58.08 a barrel between Jan. 17 and April 1 – has forced oil companies, particularly those drilling in shale plays such as Colorado’s Denver-Julesburg Basin, to make major cuts.
Three DJ Basin drillers – Whiting Petroleum, Bonanza Creek and PDC Energy – have said they will cut back operations by one drill rig each. A number of other companies have slashed their capital budgets, which include drilling.
Occidental Petroleum and Noble Energy are the state’s two largest operators. Houston-based Occidental pared its capital budget to between $2.7 billion and $2.9 billion, cut dividends to shareholders and reduced company salaries.
Houston-based Noble has said it will reduce the budget for drilling and capital investments by $500 million, or 30% , for the year, with Texas and New Mexico taking the biggest hits.
Denver-based PDC Energy and Whiting Petroleum announced capital budget cuts of nearly 30% from their planned capital budgets. Extraction Oil and Gas is reducing its budget by about 25%. In all the cuts from the three drillers total approximately $600 million.
The hedges stand out as a bright spot against this bleak financial picture and could be worth billions of dollars over the course of the year. The amount will depend upon the kind of hedge, the amount of oil hedged and the price per barrel when the oil is sold.
Denver-based HighPoint Resources, for example, said it has hedged about 95% of its anticipated 2020 oil production, equal to 64,000 barrels a day, at an average of $58.32 a barrel, making the hedges worth more than $225 million.
“This strategy has served us well and ensures a greater level of certainty to our cash flows,” Scott Woodall, Highpoint’s CEO, said in a statement.
Still, Hoge cautions that hedges don’t solve all the problems. “If you don’t have hedges you are completely exposed,” he said. “If you have hedges you are bleeding less badly.”
Nothing is guaranteed
Hedges aren’t a guarantee. Whiting, which said it has 45% of its 2020 oil production hedged at $55 a barrel, filed for Chapter 11 on April 1 in the face of more than $1 billion in debt payments.
The term hedging dates to the 16th century, when hedges were planted around fields to protect crops. Shakespeare saw hedging more broadly in his play the “Merry Wives of Windsor,” when a flat-broke Falstaff tries to woo two rich women with substantially the same love letter. Falstaff explains to his servant that he was “fain to shuffle, to hedge and to lurch.”
The aim of a modern, financial hedge, also called a derivative contract, is to fix the price or limit the drop in price for the oil. It is in essence a bet on oil prices by the operator who buys the hedge and the seller, such as an investment bank or private equity firm.
The most straightforward hedge is called a swap, in which the seller of the swap agrees to pay the difference between the hedged price and the market price if prices fall below the hedged price. If the market prices above the hedge price the oil company pays the seller of the swap the difference.
So, if an oil company hedges at $50 a barrel and the market price drops to $40 the seller of the hedge pays the driller $10 a barrel for the amount of oil hedged. If the price rises to $60 a barrel the operator pays the seller $10 for each barrel sold.
A second kind of hedge is called a collar, under which the oil company buys a “put” establishing a floor price for its oil and sells a “call,” a price at which the oil company agrees to sell the oil to the call’s buyer. This places a floor and a ceiling on the price of the oil.
A third type of hedge, which is becoming increasingly popular because it is cheaper than either swaps or collars, is a three-way collar. Like a collar, it establishes a floor and ceiling price, but then adds a second lower price, one might say, a basement price.
If the price of oil drops below the basement price the oil company only gets the difference between the floor and basement prices, plus the market price.
Occidental Petroleum, which bought Colorado’s biggest oil producer Anadarko Petroleum Corp. for $55 billion in August and is heavily in debt, has extensive hedges but they are all three-way collars.
So even though oil prices are down about $38 a barrel since Jan. 17, Occidental will get a hedging gain of about $10 for each barrel, according to Matt Hagerty, a senior energy analyst with Lakewood-based BTU Analytics.
Occidental declined direct comment for this story, referring to an earnings call with analysts in which the company said that while historically it has not hedged production it did so to strengthen its cash position in light of the Anadarko purchase.
Hedges can solve cash-flow problems
In contrast, PDC Energy has hedged about 55% of its projected oil production with swaps and collars at around $57 a barrel. “That is going to provide good cash flow,” Hagerty said.
PDC Energy declined to comment.
Three-way collars make up about 40% of the hedges, swaps 42%, collars 9%, and puts and other types of hedges the remainder, according to Rystad Energy, an Oslo-based energy consultant. The use of three-way collars this year is up 11% from 2019.
While companies disclose the amount of oil hedged and the hedging price, they do not disclose the cost of the hedge.
The eight largest publicly traded oil and gas companies operating in the Denver-Julesburg Basin have hedged between 27% and 78% of their estimated total production (including oil, natural gas and gas liquids) for the next 12 months, according to Enverus. The hedged prices are between $50 and $60 a barrel.
A Rystad Energy study found that a group of the 30 biggest, independent shale drillers, which includes six operating in Colorado, had an average of 50% of their oil production hedged with a floor price of $56 a barrel.
Noble, for example, has nearly 70% of its oil production hedged at prices about $57 a barrel, according to the study. At market prices of $25 a barrel for WTI oil, Rystad Energy calculated the companies in its analysis could reap about $17 billion in hedging gains.
“The industry is well-positioned to mitigate the effects of an oil-price collapse in the short term,” Artem Abramov, Rystad Energy’s head of shale research, said in a note.
The operative word may be short-term.
“A year’s worth of hedges in a normal market would be a cushion,” said Michael Orlando, a managing director at Econ One Research. “But we have an oil price war and what is going to be a long slow economic recovery from COVID-19.”
On March 6, negotiations between Russia and Saudi Arabia over a Saudi proposal to cut production to bolster sagging prices collapsed. The Russians refused and the Saudis countered by starting the price war, flooding the market with cheap oil.
Meanwhile, the COVID-19 pandemic has ground economies around the world to a halt and the U.S. Energy Information Administration projects a 900,000 barrel a day drop in demand for petroleum and liquid fuels in the first quarter of 2020 compared to the same period in 2019.
Even with the hedges many operators are struggling to generate positive cash flow and deal with heavy debt burdens, Hoge said.
And while some DJ Basin operators, such as Highpoint and Extraction Oil and Gas, say they have ample hedging positions in 2021, overall Enverus calculates that the volume of oil hedged drops 93% in 2021.
“What do they do when the hedges are over?” Orlando asked. “How are they going to respond?”